Understanding Index Investing

by Wealth Architects / 30.04.2019

It’s more than likely that you’ve come across the term Index when it comes to investing. And that would be no surprise given the amount of funds flowing into Index funds have continued to grow over time. In Australia, approximately $377 billion is invested in index funds. This represents about 16% of the total investment management market 1.. In this article we breakdown what all the fuss is about and why it remains a core strategy for our clients:

First of all, what is an Index fund?

Index funds are an effective way of gaining exposure to a particular investment market. Most investment markets have indexes that measure their value over time. There is an index for almost every asset class and industry sector, including Australian and international shares, property, bonds and cash.

How is indexing different to other forms of investing?

Active fund managers and stock pickers attempt to beat the index by selecting sectors and securities they believe will outperform in the future. This approach is also adopted by many industry and retail super funds in their underlying portfolios.

As an alternative to this approach, you can simply invest in an index fund which replicates a particular market or sector, for example the ASX 300 (the top 300 companies listed on the Australian Stock Exchange). In this particular example, you would own a small portion in each of the top 300 companies in proportion to their size in the index. You can replicate the same approach in many other indices, for example the MSCI World Index, the Bloomberg AusBond Composite Index or even something a little more unconventional like the Crude Oil Index.

OK, so why invest in an Index Fund?

1. Long-term performance

Index investors hold the belief that generally, it is very difficult to beat the market (index) return, particularly on a consistent year after year basis, and the evidence speaks for itself. In 2018, 87% of Australian share funds were beaten by the index return and the percentage was over 70% for International Share Funds2.

2. Diversification

Investing in all or a representation of stocks in a market index can maximise diversification and reduce risk, simply by virtue of having more stocks in your portfolio. Typically, an active fund or direct share portfolio are much more concentrated and are therefore heavily reliant on the return of each underlying stock.

3. Low costs

Index funds usually have significantly lower costs, compared to active funds for 2 main reasons. Tracking an index is an easily repeatable investment process and hence does not need to rely on highly paid portfolio managers to research and analyse securities to invest in. In addition, the underlying portfolio in an index is generally traded less frequently, which means you save on brokerage, commissions and other trading expenses.

So how do you invest in an index fund?

Given their growing popularity, there are now a myriad of index funds and providers and varying ways to access them. Deserving of a separate article all together, we have instead provided a list of the most common ways to invest in an index below:

1. Through a stockbroker via an Exchange Traded Fund

2. Directly through an index provider (limited providers)

3. Through an investment platform – put simply an administration service/structure that allows you to access many types of investments, not just index funds

Final Word

Along with many other seasoned investors and professionals including Warren Buffet, Tony Robbins and Scott Pape, we have a strong conviction towards passive investing for the reasons outlined above however it certainly is not a one-size-fits all approach. There are many circumstances where other types of investing are justified and as always, we encourage you to reach out to discuss what approach might be appropriate to your circumstances.

Disclaimer: The content of this article is general in nature and is presented for informative purposes. It is not intended to constitute financial advice, whether general or personal nor is it intended to imply any recommendation or opinion about a financial product. It does not take into consideration your personal situation and may not be relevant to circumstances. Before taking any action, consider your own particular circumstances and seek professional advice. This content is protected by copyright laws and various other intellectual property laws. It is not to be modified, reproduced or republished without prior written consent.